Overheads in Cost Accounting refer to the indirect costs incurred in the production of goods or rendering of services that cannot be directly traced to a specific product, job, or process. These costs include indirect materials, indirect labour, and indirect expenses associated with manufacturing, administration, selling, and distribution activities. Overheads are allocated or apportioned to different cost centres and absorbed into the cost of products or services using suitable overhead absorption methods.
Table of Contents
- Classification
- Types of Classification
- Allocation and Apportionment (Primary Distribution of Overheads)
- Secondary Distribution of Production Overheads
- Capacity
- Absorption of Overheads
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1. Classification
Classification is defined by CIMA as, ‘arrangement of items in logical groups having regard to their nature (subjective classification) or the purpose to be fulfilled (objective classification). In other words, classification is the process of arranging items into groups according to their degree of similarity. Accurate classification of all items is actually a prerequisite to any form of cost analysis and control system.
2. Types of Classification
2.1 Elementwise Classification
- Indirect Material
- Indirect Labour
- Indirect Expenses
2.2 Functional Classification
- Factory (or Manufacturing or Production) Overhead
- Office and Administration Overhead
- Selling and Distribution Overhead
2.3 Classification Based on Behaviour
- Fixed Overheads/Period Costs
- Variable Overheads
- Semi – Variable Overheads
3. Allocation and Apportionment (Primary Distribution of Overheads)
Allocation of overhead means charging of overhead to a particular cost centre when such overhead has been incurred directly for that cost centre. If the overhead is directly related to a particular cost centre or department, it is charged to that.
Apportionment of overhead means those overheads which are not directly identifiable with any particular production or cost centre, are distributed over the departments/cost centres on some equitable basis. These are joint costs whose benefits are commonly shared. For example, the benefits of rent or electricity cannot be identified with any particular department. So, these overheads have to be apportioned.
4. Secondary Distribution of Production Overheads
After the primary distribution the next step is to reapportion the service department costs over the production departments. This also needs to be done on some suitable basis, as there may not be a direct linkage between services and production activity.
4.1 Methods of Secondary Distribution
(a) Direct Distribution Method – This method is based on the assumption that one service department does not give service to other service department/s. Thus, between service departments there is no reciprocal service exchange. Hence, under this method, service costs are directly loaded on to the production departments.
(b) Step Distribution Method or Non-reciprocal Method – This method is based on the assumption that one service department gives service to the other but does not receive service from other service department.
In such situation, cost of that service department will be distributed first which render services to maximum number of other service departments. After this, the cost of service department serving the next large number of departments is distributed. This process is continued till all service departments are over, because it is done in steps, it is called as Step Distribution Method.
c. Reciprocal Service Method – This method takes cognizance of the fact that service departments may actually give as well as receive services from and to the other service departments on reciprocal basis.
(i) Repeated Distribution Method – This is a continuous distribution of overhead costs over all departments. The decided ratios are used to distribute the costs of service departments to the production and other service departments. This is continued till the figures of service departments become ‘nil’ or ‘negligible’.
(ii) Simultaneous Equations Method – Under this method, simultaneous equations are formed using the service departments’ share with each other. Solving the two equations will give the total cost of service departments after loading the interdepartmental exchange of services. These costs are then distributed among production departments in the given ratio.
(iii) Trial and Error Method – This method is to be followed when the question of distribution of costs of service cost centres which are interlocked among them arises. In the first stage, gross costs of services of service cost centres are determined. In the second stage cost of service centres are apportioned to production cost centres.
5. Capacity
5.1 Theoretical or Maximum Plant Capacity
Maximum Capacity or the Ideal Capacity is the capacity for which plant is designed to operate. It is only Theoretical Capacity. It does not give allowance for waiting, delays and shut down.
5.2 Practical Capacity
When this capacity is determined, allowance is given for unavoidable interruptions like time lost for repairs, inefficiencies, breakdown, delay in delivery of raw material and supplies, labour shortages and absence, sunday, holidays, vacation, inventory taking etc. Thus, practical capacity is the maximum theoretical capacity with minor unavoidable interruptions.
5.3 Normal Capacity
Idle capacity due to long term sales trend only is reduced from practical capacity to get normal capacity. Calculation of normal capacity of a plant presents considerable problems. Normal capacity is determined for the business as a whole. Then, it is broken down by plants and departments.
5.4 Capacity Based on Sales Expectancy
Capacity may be based on sales expectancy for the year. The distinction between normal capacity and capacity based on sales expectancy should be properly understood. While normal capacity considers the long-term trend analysis of sales, which is based on sales of a cycle of years, the capacity based on sales expectancy is based on sales for the year only.
5.5 Idle Capacity and Excess Capacity
The difference between practical capacity and normal capacity, i.e., the capacity based on long term sales expectancy is the idle capacity. However, if actual capacity happens to be different from capacity based on sales expectancy, the idle capacity will represent difference between practical capacity and actual capacity.
Excess capacity results either from managerial decision to retain larger production capacity or from unbalanced equipment or machinery within departments. Excess capacity refers to that portion of practical capacity which is available, but no attempt is made for its utilisation for strategic or other reasons.
6. Absorption of Overheads
The absorption of overhead enables a Cost Accountant to recover the overhead cost spent on each unit of the product. Overhead absorption is also known as levy or recovery of overheads.
Absorption means ‘recording of overheads in Cost Accounts on an estimated basis with the help of a predetermined overhead rate, which is computed at normal or average or maximum capacity’
6.1 Overhead Absorption Rates
- Actual Overhead Rate – Actual overhead rate is obtained by dividing the overhead expenses incurred during the accounting period by actual quantum on the base selected.
- Pre-determined Overhead Rate – Predetermined rate is computed by dividing the budgeted overhead expenses for the accounting period by the budgeted base (quantity, hours etc.)
- Blanket (Single) Overhead Rate – A single overhead rate for the entire factory may be computed for the entire factory. So, this is known as factory wide or blanket overhead rate method.
- Multiple Rates – This method is most commonly used to determine the multiple overhead rates i.e., separate rate:
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- For each production department;
- For each service department;
- For each cost centre; and
- For each product line.
6.2 Methods of Overhead Absorption
- Production Unit Method – The concept here is to average out the total overheads on total units produced.
- Percentage of Direct Wages – Under this method, overhead for a job is recovered on the basis of a pre-determined percentage of direct wages.
- Percentage of Direct Material Cost – Here the absorption rate is expressed as a percentage of direct material cost.
- Percentage of Prime Cost – This method combines the benefits of direct wages and direct material cost methods as we know prime cost means the sum total of direct material cost, direct labour cost and direct expenses.
- Direct Labour Hour Rate – Under this method, the absorption rate is calculated by dividing the overhead amount by the actual or predetermined direct labour hours. The labour hour rate may be calculated as a single rate or different for different group of workers.
- Machine Hour Rate – This is the rate calculated by dividing the actual or budgeted overhead cost related to a machine or a group of machines by the appropriate number of machine hours. These hours could be actual hours or budgeted hours.
6.3 Under-absorption and Over-absorption of Overhead
The amount of overhead absorbed in costs is the sum total of the overhead costs allotted to individual cost units by application of the overhead rate.
If the amount absorbed is less than the amount incurred, which may due to actual expenses exceeding the estimate and/or the output or the hours worked being less than the estimate, the difference denotes under absorption.
On the other hand, if the amount absorbed is more than the expenditure incurred, which may be due to the expense being less than estimate and/or the output or hours worked being more than the estimates, this would indicate over-absorption.
6.4 How does one deal with the situation of over or under absorption?
There are three ways to handle over or under absorption:
- Write off (in case of under-absorption) or write back (in case of over-absorption) to the Profit and Loss Account. This treatment is valid if most of the overhead items are related to time.
- Carry Forward to the Next Period Through a Reserve Account – this method is not recommended on the logic that it is inconsistent with Accounting Standard.
- Use of Supplementary Rates – to adjust the effect to the cost of sales, finished stocks and work in progress stocks. This sound logical as it does not carry forward the unabsorbed or over-absorbed overheads to the next accounting period entirely. It aims at splitting the total effect between the cost of sale (which is charged to current year’s profits) and stocks (which is carried forward to the next year).
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